The Best Book For Your Personal Finances: Psychology of Money
There are many books about money, investing, financial success, … and I’ve read many of them. However, there has been one book that stood out for its practical recommendations without fluff and with realistic suggestions: Psychology of Money by Morgan Housel.
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| Photo by Morgan Housel on Unsplash |
Essentially the book consists of 21 principles about investing and money. In this article, I’ll summarize the essence of these principles.
1. No One’s Crazy
Everyone has grown up with different environmental conditions and has been shaped by them in the area of finance.
Someone who lived through the Great Depression or was damaged by the financial crash of 2007/08 will be more cautious about stocks than someone who grew up in the 90s.
The essence is: that everyone is only as crazy as the environment they grew up in.
2. Luck & Risk
It is common knowledge that luck and risk are closely intertwined.
This can be explained with e.g., the success story of Bill Gates: Bill Gates and Paul Allen were lucky (1:1,000,000) that they went to school in the right high school. It was a high school with time-sharing of the GM mainframe. This allowed them to spend a lot of time with an excellent PC and they quickly became computer experts, which (according to Bill Gates himself) was an important key criterion for their later success with Microsoft.
But there was a third computer geek in the group with them: Kent Evans. However, he died in a mountain accident in his youth. This is a risk that also has a probability of 1:1,000,000.
3. Never Enough
This is about wanting “more”.
One of the biggest challenges in the context of money is recognizing when you have enough of it.
A story that underlines that is that of Rajat Gupta, a former McKinsey CEO who had more than 100 million euros in assets but wanted to join the ranks of billionaires. He therefore engaged in insider trading for a while, but was then caught - he lost his reputation and most of his fortune. He just wanted too much.
The essence: think of how “enough” looks like for you.
4. Confounding Compounding
Compounding interest is powerful.
Take Warren Buffet’s success for example: over 99% of his wealth has come from compound interest and his secret is the consistency and duration of his investments.
By investing in the stock market for almost 75 years, he has been able to make good use of the effect and his average return of 22% has increased. The duration alone makes him 75% wealthier than the most successful hedge fund manager with a return of over 60% and that is “only” due to the long time Warren Buffet has been invested and benefited from the compound interest effect.
So in essence: time is working for you!
5. Getting Wealthy vs. Staying Wealthy
Becoming wealthy and staying wealthy are two very different tasks.
If you never have enough and take very high risks for things you don’t need, you are jeopardizing your ability to stay wealthy, or in the words of Warren Buffet: you should never risk something you need to gain something you don’t need.
There are two basic rules for staying wealthy:
- Live as frugally as possible.
- Have a certain amount of paranoia.
6. Tails, You Win
Tails are extreme values/events.
Think of an art collection. Art collectors are successful because they diversify strongly and buy many art objects. In this way, they increase their probability that the lucrative 1% will outshine the remaining investments.
Warren Buffet and Charlie Munger also say that Berkshire Hathaway’s great success ultimately boils down to just the 10 best stocks.
In the case of investing such extreme events can be a market crash. A good strategy here is to keep calm, or in the words of Napoleon: “In war, those who do ordinary things are the most successful, while the majority goes mad.”
7. Freedom
Freedom is the best dividend that money pays and studies show that freedom has a tremendous impact on our happiness.
Why?
Freedom means that people can decide what to do with their time. And is there something better than that?
While inflation-adjusted prosperity in the West has grown in recent decades, happiness has stagnated. One explanation is that the proportion of our freely determined time has decreased (with knowledge work, we take our work home with us - often unintentionally).
The essence: It is not the shiny object we should be after, but the freedom money can buy us!
8. Man in the Car Paradox
The “Man in the car paradox” means that we believe we appear successful to others when we are sitting in an expensive car.
But the reality is that others don’t even notice the person in the car. On the contrary: the person sitting in the car is replaced in our minds by ourselves: we imagine what it would be like to drive such a car.
This underlines (7) even more: don’t chase shiny objects!
9. Wealth is What You Don’t See
Being wealthy and being rich are two very different things:
- Wealth is what you can’t see: Assets you could consume.
- Being rich, on the other hand, is what you can see: expensive things and luxury goods. So you can look rich without being wealthy.
Ultimately, however, it is wealth that pays the biggest dividend: freedom (and flexibility) to choose what you do at any given time. This could be quitting an unloved job, taking advantage of an opportunity, or sleeping stress-free.
If you do everything you can to look rich, this can have the opposite effect: you are stuck in a situation (e.g. in an unloved job) to be able to afford the “rich lifestyle”.
10. Save Money
Saving is what makes you wealthy, not owning expensive luxury goods. At best, it makes you look rich, but this leads to the “Man in the Car Paradox”.
If you save consistently, this has one of the greatest effects on your wealth. As already discussed in (6), it is the “tails” that win, and the longer you are in the game, the higher the probability that you will catch one or more of the tails.
11. Reasonable > Rational
When investing, it is more important to be reasonable than purely rational.
Humans are emotional beings who don’t always make the rational-best decision. It can be emotionally challenging to always make the most rational decision.
As shown in the previous principles, consistency and time are the most important factors in investing. It is better to make reasonable decisions consistently than to force yourself to make rational decisions for a certain period and then give up.
The essence: Stay reasonable in your decision-making.
12. Surprise!
The bottom line is that surprising events occur more often than you think.
These can be “tails”, but also recessions and market slumps.
It is crucial to be prepared for these surprises: e.g. by having liquid funds that can be invested when a good opportunity arises or used for living expenses in bad times (so that no cash-out is necessary).
The essence: Don’t be over-pessimistic and also don’t be over-optimistic.
13. Room for error
Especially in finance, it is always assumed that the past is a good predictor of the future.
However, there are always surprising situations that occur. People are bad at imagining situations that have never happened before (e.g. flood marks in ancient Egypt & Fukushima). It is therefore important to plan in a “room for error”
What can be helpful for the human psyche is to divide the investments into two pots: (i) a pot for riskier investments such as shares and (ii) a safety pot. The latter can be seen as a hedge asset of the former. In bad times (if the market drops by 30%), you can fall back on the first pot and remain invested, thus avoiding losses.
In this context I like the following quote:
The best plan is to plan for the plan not going according to plan.
14. You’ll Change
People change and so do attitudes to finance and investing. We find it hard to imagine where we will be in 10 years: emotionally and physically.
The best advice to be prepared for the change is to never accept extreme circumstances (very long commutes, enormously long working hours, etc.).
If you only accept “mediocre” things, it is more likely that they will still fit when the environment and you change.
The essence: never accept extreme circumstances.
15. Nothing’s Free
This is a short, but important one: The price of investing is volatility. If you don’t accept some risk, you won’t have many growth opportunities.
16. You & Me
A bubble in the stock market is not caused by everyone pricing a stock above its value but is usually influenced by a specific group of investors: day traders.
They don’t look at the long-term success of companies, but trade based on trends. They sometimes even buy a share (which is overvalued for long-term success) if the trend is positive in the short term.
The lesson is that whether a stock is overvalued or undervalued always depends on the individual and their investment strategy.
17. The Seduction of Pessimism
We give more credence to overly pessimistic assessments (e.g. crisis prophets) than to exuberantly optimistic assessments. This is, in the terms of Daniel Kahneman, the loss aversion (cf. Thinking, Fast and Slow).
18. When You’ll Believe Anything
You just don’t know, what you don’t know. - Donald Rumsfeld
Markets are not precise and finance is not an exact science (like physics) - it is driven by human attitudes and we are all different as underlined in (16).
19. All Together Now
This section of Morgan Housel’s book summarizes the principles 1-18.
One key learning that is emphasized on: you don’t have to have a goal to save for (a car, a down payment on a house, etc.). You can simply save for future risks, ideas, and freedom.
20. Confessions
This is a personal section where Morgan Housel shares how he and his family invest.
How does a financial expert invest?
You’d guess rather risky right?
No, Morgan Housel is much more conservative than many others (especially in the financial sector).
- He did not take out a loan for his house but paid for it purely from his assets.
- He also holds 20 % of his assets (excluding the property) in cash. From his point of view, cash is the part of the portfolio that provides the most freedom/independence.
In addition to funds for their children’s education and the American “retirement funds”, Morgan Housel and his wife have invested their money in index funds. The aim of the investments is independence. Their strategy is as follows:
- Optimism that the international economy will be successful and profitable in the long term.
- Living below one’s means and saving the surplus.
21. A Brief History of Why the U.S. Consumers Think the Way They Do
In this postscript, Morgan Housel tells the story of U.S. consumers and how their behavior came to be.
In the aftermath of World War II, when the economy needed to absorb those returning from the war - GIs wanted housing, marriages, and jobs. Cheap loans were developed to meet the demand and a period of economic boom began.
Until the 1970s, there were few extremes in the US population - wealth was roughly evenly distributed: Middle class and rich had similar TVs, cars, etc. But as the boomers grew up, this shifted more and more.
To live as “well” as the top 10%, the middle class had to rely more and more on credit, but since they were used to everyone being roughly equal from their youth, middle-class consumers saw it as their privilege to own “good” things. This is how credit-based consumption came about in the USA.
Thank you for reading my article about the Psychology of Money. I enjoyed reading this book and took some valuable learnings with me. If you are interested and want to learn more, I can highly recommend reading the whole book.